Exchange Rate Alignments

The economic history of the developing world since the start of industrialisation has been remarkably uneven. Britain experienced an unprecedented period of rapid growth in the first half of the nineteenth century, but then slowed down between 1850 and 1900. The USA grew rapidly during the whole of the nineteenth century and, more intermittently, through to 1945, but then slowed relative to new challengers. Germany and the Netherlands did much better during the second half of the nineteenth century than the first, and better still during the early years of the twentieth century, leading up to World War I. The 1930s were a particularly interesting and important period, with the USA and France languishing, Britain doing far better than previously and Germany surging ahead at an astonishing pace. There have been decades when most of the most prosperous economies of the time were expanding very quickly, as they did in the 1950s and 1960s, although the USA’s did not grow as fast as others’ during these decades. In the 1970s, after the post-war boom, increases in output slowed in the developed countries. The world’s growth rate of 4.9 per cent per annum cumulatively between 1950 to 1973 slowed to 3.0 per cent from 1973 to 1992 ¹ and then rose a little, to 3.4 per cent, between 1992 and 2009. ² Crucially, however, lower growth rates in the later periods were far more marked in those economies where relatively high standards of living already prevailed, notably in western Europe and Japan, where they averaged 2.2 per cent over the years 1992–2009. ³

Rapid growth takes place in economies which are competitive in world markets and start with the advantage of costs at least as low as their competitors’ (preferably lower). This advantage, by enabling them to expand exports without suffering excessive import penetration, provides them with opportunities to increase their share of world trade and to grow without the constraint of balance of payments problems. Internal demand can then be kept at a high and rising level, without undue inflationary pressures developing. These conditions were established and maintained for the USA during the nineteenth century and some of the first half of the twentieth, albeit behind high tariff barriers which had other disadvantages. They applied to most of the rest of western Europe — excluding Britain, which grew much more slowly — during the quarter of a century after World War II ended. The same conditions are to be found now in the fast-growing economies in the Far East. The reason why such sustained growth has been achieved, why living standards much more than doubled in the course of less than two decades, why inflation has in nearly all cases been relatively low and stable, is that the macroeconomic conditions have been right.

Few topics are as loaded with ideological baggage as whether inflation, at least in moderation, is desirable or a scourge. It is also clear, at least in nearly all the Western world, which side has won this particular battle of ideas. It is now the conventional wisdom almost everywhere that one of the most significant objectives of economic policy — perhaps the most important of all — is to maintain the average increase in the price level at no more than or about 2 per cent.

Since about 1970, an extraordinary change has taken place across much of the developed world. It has been the huge growth in unemployment, matched by the inability of policymakers to do anything effective to reverse it. Unemployment in the European Union has hovered close to 10 per cent for most of the last four decades and in September 2011 it stood at 10.2 per cent. Twenty-three million people in the EU were actively looking for jobs. ¹ For much of the period since 1970, US unemployment has been lower than Europe’s, mainly because of its much harsher regime for those out of work. In October 2011, however, with 9.0 per cent of the labour force registered as being out of work, the US percentage had grown nearly as high as in the EU. ²

Changes in policy which succeeded in increasing the rate of economic growth among Western economies would inevitably increase the pressure on the world’s ecology. Higher output would raise consumption of raw materials and produce more waste. Raising living standards could, unless carefully handled, substantially increase rather than reduce the risk of destabilising the world’s climate. Can, therefore, a convincing case be made that a policy orientated to producing better economic performance, as conventionally measured, is likely to be self-defeating? While this line of attack has always had a vocal constituency, there are strong arguments that this view is much too pessimistic. From all major perspectives, the prospects for a sustainable future — and increased human happiness — look to be much better if the developed countries of the world are stable and prosperous than if they are teetering towards financial disaster, with all the social and economic problems that such a scenario would bring in train.

So far the case for major changes in economic policy priorities set out in this book have been largely theoretical. If they are to be a basis for deciding how to tackle some of our most pressing problems, it would help enormously if they could be shown not only to provide persuasive abstract theoretical constructs but also to be soundly based on empirical evidence. Apart from any merit that internal coherence and credibility may give them, is it possible to adduce evidence to validate them? If they can pass this sort of test, there would be much more solid reasons for believing that they can provide reliable guidance for future policymaking.

World War I began as the result of a network of treaty obligations being called into play following the assassination of Archduke Franz Ferdinand (1863–1914) in Sarajevo on 28 June 1914. ¹ Although few had anticipated the outbreak of war, its advent was greeted with a surprising amount of enthusiasm. Huge crowds turned out in Berlin, Paris, Petrograd (Saint Petersburg), London and Vienna, clamouring for military action. ² By 1945 all such enthusiasm for war had been spent. Two ruinous conflicts had cost millions of lives, caused untold damage and set back the advance of living standards by an incalculable amount. Not only, however, had immense human and physical damage been done during the periods of open warfare. In addition, the network of international trading and financial arrangements which had allowed the world economy to function reasonably smoothly during the nineteenth century and the early years of the twentieth was catastrophically disrupted by the impact of World War I. The result was a period great instability and lost opportunities between the wars, as fragile booms in the 1920s collapsed into the worldwide slump of the early 1930s. Thereafter, there were sharp divergences, as some economies continued to decline while others made remarkable recoveries.

World War II was an even worse disaster for the world in loss of life and material destruction than was World War I. Many more people were killed in the hostilities. The increased destructiveness of the weapons used, particularly those involving aerial bombardment, caused far more damage to railways, houses and factories than had occurred during World War I.

As the certainties of the Bretton Woods world crumbled away in the early 1970s, intellectual fashions in economics moved decisively away from the Keynesian orthodoxy of the previous quarter of a century. Monetarism became the theoretical and practical discipline to which the vast majority of those involved in economic affairs, in both the academic and policymaking worlds, began to subscribe. It is no coincidence, however, that monetarism’s prevalence has been highly correlated with deteriorating economic performance. Monetarist doctrines are inclined to receive their most sympathetic hearing among political and intellectual leaders who are at the helm of the slowest growing economies. There are interlocking reasons why this is so. It is partly that monetarist prescriptions lead to slow growth and partly that the cultural attitudes which breed a proclivity for them flourish especially strongly in economies with poor growth and employment records.

In retrospect, 2000 to 2008 may very well turn out to be viewed as the last years during which Western economies did reasonably well before the storm to come. At least on the surface, in the USA and Europe economic performance seemed satisfactory and relatively stable, as the US economy, helped by rapid rises in the value of housing, recovered from the dot-com boom and bust of the late 1990s and several economies in Europe boomed on the strength of low Eurozone interest rates. Inflation everywhere was low, averaging 2.3 per cent in the USA and 2.1 per cent in Europe. ¹ In many countries property values, thanks to historically low interest rates, increased markedly, making property owners feel richer. From 2002 to 2007 average UK house prices rose 90 per cent, ² and over 200 per cent in Ireland between 1997 and 2007. ³ Stock exchanges recovered strongly. In the USA the Dow Jones Industrial Average almost doubled between 2002 and 2007, ⁴ with similar increases in Europe. The euro, established in 1998 as the constituent currencies were locked together and the currency in day-to-day use throughout the Eurozone since 2001, appeared to have got off to a good start. Living standards rose, too, although averages could be misleading. A very high proportion of increased GDP everywhere, particularly the USA, went to the already well off.

The evidence presented in this book so far indicates that the West does not have a viable set of economic policies capable of guiding it to a sustainable economic future, which is generally accepted by policymakers, a majority of the informed public and by most academic commentators. Instead, in the absence of a viable consensus, there appears to be a major risk that – at best – the Western world is headed for a long period of slow or non-existent growth. At worst the picture could be much gloomier. If many Western countries’ policies to reduce fiscal deficits depress not only their economies but their export markets for the other Western economies in the same condition, a major depression could result. If the authorities in these countries then continue to pursue the same policies as they have up to now, they will be left with no weapons to fight the falling living standards, rising unemployment and political dissatisfaction which will result.